Hello readers,
Long-term subscribers will know that we don’t pay attention to crypto news cycles. Instead, we spend our time studying technology from first principles. Analyzing on-chain data. Preparing valuation frameworks for crypto networks and protocols. Projecting how services will be bundled and unbundled on public blockchains. And forecasting the viability of new Internet native business models.
This allows us to focus on the big picture while cutting out the incessant noise in the industry.
I’m prefacing this because last Thursday a big news story broke. It’s so big we can’t ignore it.
So we’re switching gears. This week’s report will be more of a stream-of-consciousness post covering my reaction to the Ripple court case and what it means moving forward.
Disclaimer: Views expressed are the author's personal views and should not be taken as investment or legal advice.
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Let’s go.
The SEC has been spending millions of taxpayer dollars trying to convince the general public that every crypto-asset in existence (except Bitcoin) is a security.
Their stance is that the entire industry is breaking federal law.
As such, the agency has initiated numerous investigations of crypto companies. Investigations often lead to enforcement actions — forcing start-ups to expend critical resources on hefty legal bills (estimates indicate Ripple spent $100m defending itself). In total, the SEC has brought over 127 enforcement actions against crypto companies. The vast majority of these actions have to do with the sale of what the SEC claims are unregistered securities.
But guess what?
In the most important lawsuit to date, the court ruled against the SEC.
3 Important rulings by Judge Analisa Torres :
The Judge ruled that when Ripple initially raised capital, they sold unregistered securities. This pertains to capital received from VCs, hedge funds, and other institutions that seeded the initial development of the project. Ripple could have avoided this outcome by filing a Reg. D form with the SEC — which is typically what start-ups (including crypto) do when raising capital. Ripple will pay fines. But this part is inconsequential to the crypto industry.
More importantly, the court ruled that when Ripple “programmatically” sold tokens (transactions executed via blind bid/ask order books on exchanges), these were not securities transactions.
The court ruled that when Ripple paid employees and ecosystem partners in XRP, the native token of the network, these also were not securities transactions.
The court ruled that individuals exchanging assets in blind bid/ask transactions are not investing in a common enterprise with an expectation of profits. Essentially, there is no investment contract. The Howey Test is not met. This is precisely what we wrote about in our recent post on crypto regulations when we analyzed the SEC’s case against Coinbase.
This is a HUGE WIN for crypto exchanges. Coinbase shot up 25% after the court ruling hit the newswire.
It’s a HUGE WIN for Ripple and XRP token holders. The token shot up 70% and was re-listed on major exchanges such as Coinbase. *This is not an endorsement of the XRP token.
It’s also a HUGE WIN for any crypto project currently trading on an exchange. The SEC has made several statements calling out various crypto assets as unregistered securities. ADA, CHZ, SOL, FIL, ICP, FLOW, NEAR, MATIC, SAND, ALGO, ATOM, etc. have all been publicly named. In total, over 67 projects have been identified as unregistered securities by the SEC. The market responded in kind for these projects when the news broke.
If XRP — a centralized project from my view — is not a security, then what crypto asset *is* a security? It seems reasonable to imply that all crypto assets can now freely trade on exchanges as non-securities transactions.
The bottom line is the SEC needed to prove that crypto assets trading in secondary markets are securities transactions.
They lost.
Of course, the SEC will probably appeal the judges ruling. My lawyer friends are telling me that could take another 2 years to play out.
I realize the court system is messy. But how can anyone in their right mind argue that this is an appropriate use of taxpayer money?
Is it possible that these funds would be better spent working with the industry to craft new rules and regulations?
To remove information asymmetry in the markets?
To protect the investing public?
To foster capital formation and new innovation?
Seriously. And how does any of this align with the fundamental values of America?
Goodness, gracious. I’ll stop asking questions now.
As stated, the SEC will likely appeal the ruling. And they may have some solid footing to do so.
One question I’m still asking myself: how can a token issued to institutional investors be considered a securities transaction, but anonymous sales of the same token (via exchanges & market makers) to retail investors not constitute a securities transaction?
If I’m understanding this correctly, the court’s ruling could incentivize shady crypto companies to bypass institutional investors altogether — something we see on questionable launchpads such as Binance.
Of course, this is not how it works in the stock market. Investors that bought Apple shares pre-IPO engaged in securities transactions. As do investors buying on the secondary markets today.
I don’t want to be a wet blanket. But we might not be out of the woods just yet.
The bottom line is that the industry needs new rules, regulations, and laws. Crypto markets have historically been ripe for fraud, pump & dump schemes, and market manipulation. It’s not about whether something should be done or not. It’s about who has the authority to do it.
In the United States constitutional system, it is Congress that has the authority to establish a regulatory regime for the emerging crypto ecosystem — not the SEC.
My hope is that the ruling by Judge Analisa Torres in the Ripple case is the turning point for Congress to take action.
And for Gary Gensler to take his ball and go home.
In this case, the SEC will be tasked with enforcing new rules created and voted on by Congress. This is what the SEC is good at. And they have a great track record. The US controls over 40% of the global capital markets yet has just 4% of the global population. We need the SEC.
But we don’t need them stifling innovation.
Let’s not forget that the Judge ruled that when Ripple initially raised capital, they were issuing unregistered securities. As mentioned, when a start-up raises capital, they typically file a Form D exemption with the SEC. Ripple did not do this. And so now they’ll pay some fines. Again, this is *not* the key takeaway from the case.
But it begs the question: if a start-up raises capital and issues traditional securities (subscription agreements) to seed investors, can it still issue a token later?
What will this process look like?
Below is a 7-step guide to where I think we ultimately end up. Of course, Congress will make the new laws. This framework is just me looking forward and reading the tea leaves. If you’re an entrepreneur looking to launch a token project, please do not take it as legal advice.
Crypto start-ups will raise capital from VCs, hedge funds, angel investors, etc. They will file Form D with the SEC when they do this. They are issuing *securities* via traditional subscription agreements and funding the project at this state. The SEC has jurisdiction. *To be clear, most start-ups are already doing this today.
Seed investors receive subscription agreements. Within the agreement, the start-up will indicate whether they expect to issue a token when they become “sufficiently decentralized” — as defined by new legislation. Agreements will lay out the terms with seed investors receiving token allocations pro-rata to their investment.
Upon meeting the timelines and criteria for sufficient decentralization, the project will issue tokens to market makers via exchanges. This is their “going public” moment. Tokens trading on exchanges will not be securities transactions. Rather, sufficiently decentralized token projects will constitute digital commodities. The CFTC will oversee crypto exchanges & secondary markets.
Exchanges will need to comply with a series of investor disclosures upon listing the token.
When the token lists on exchanges, the project will simultaneously list with an on-chain data provider platform such as Token Terminal. A firm like Token Terminal essentially becomes the Yahoo Finance or Edgar Database for crypto markets. This gives the investing public full transparency into the project’s business model, revenues, treasury, value locked, users, developers, token allocations & vesting schedules, etc. Essentially, information asymmetry is removed from the market via access to continuous financial statements and on-chain data.
Third parties will audit Token Terminals data visualizations and the listing project’s smart contracts.
Crypto analysts will provide buy/sell side analysis using new valuation frameworks and yet to form market consensus regarding appropriate benchmarks, KPIs, metrics, and relevant data.
That’s how we see it playing out. What do you think?
Let me know in the comments.
The tipping point for crypto to go mainstream took a giant step forward last week.
Meanwhile, if I told you 6 weeks ago that Blackrock was going to file for a Bitcoin ETF, Ripple would win their case against the SEC, and the Fed would pause rate hikes, you’d probably be quite pleased.
Well, here we are.
That said, we’re cautious in the short term. The markets are somewhat exuberant right now (crypto + equities). We think this could continue through the summer. It looks like the Fed will hike one more time. Of course, inflation is cooling off. The economy is slowing.
Thanks for reading.
We’ll shift back to the usual content in the coming weeks & months. Here’s what we’re cooking up for you:
An update to our Ethereum valuation framework including price predictions
An update to our long-term thesis for web3
Why crypto is on a collision course to merge with TradFi
How E&Y could be the catalyst to onboard enterprises to Ethereum
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Disclaimer: Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied.